Investigating Discretion in Executive Compensation: Extracting Private Information from Valuation Allowance Decisions

Abstract

We investigate how boards incorporate private information about managerial performance in compensation and turnover decisions. Building from the literature documenting that loss firms’ publicly available valuation allowance (VA) disclosures contain value-relevant private information, we show that the decision of whether or not to record a VA also captures contract-relevant private information. We develop an approach to extract a private, firm-specific, time-varying signal of managerial performance by inferring a more positive (negative) private signal when the VA decision suggests the firm expects the loss to be transitory (persistent). Our empirical analyses rely on a joint test of whether the VA decision reflects a private signal of managerial performance and whether the board uses this private information in contracting. Confirming our hypothesis, we document significantly larger discretionary compensation for transitory loss-firm CEOs, relative to persistent loss-firms. We also show that the VA decision informs the weighting of earnings in determining CEO compensation. Additionally, we provide evidence that the likelihood of CEO turnover is lower in transitory loss-firm years relative to persistent loss-firms. Overall, extracting private information from the VA decision provides an innovative way to extend our understanding of how boards use discretion in contracting.

Keywords: executive compensation, loss firms, valuation allowance

JEL Classification: J3, M41, H25